How to keep supply chains reliable when the world's upended

In March, as COVID-19 cases spiked across the United States, hospitals faced a harrowing shortage of crucial medical supplies, from face masks and ventilators to the nasal swabs and chemicals needed for testing kits. In the ensuing weeks, there's been a growing concern over wider drug shortages, since—according to FDA figures—72% of active-ingredient manufacturing for medicines sold in the U.S. is based in other countries.

"This health crisis has really shown how fragile those supply chains are and how much we rely on them," says Kostas Bimpikis, an associate professor of operations, information and technology at Stanford Graduate School of Business.

For Bimpikis, that fragility is the result of multiple firms designing supply chains—increasingly complex ones—that achieve targeted business goals but fail to protect the resilience of the network as a whole. And because this is true of nasal swabs as much as sneakers and iPhones, it can lead to the kinds of vulnerabilities we are experiencing now.

So how does the country prevent such costly disruptions? Bimpikis says there might be a role for the government to monitor critical supply chains to ensure that they remain viable even in times of emergency.

"Companies build supply chains based on their own incentives, not the health of the network as a whole, so you can't expect such networks to be optimally resilient," he says. "The only way to ensure that would be some kind of government intervention."

Taking the Network's Point of View

There's a reason companies choose to move production overseas and keep a "lean" inventory: It reduces costs and improves profits. Disruptions are always a threat, of course, but most firms have factored in that risk when designing supply chains. What they usually don't factor in is the aggregate risk to the industry that results from each firm making decisions based exclusively on its own self-interest.

This tension between the company and the network has been the focus of much of Bimpikis' research. The risks look different when you take the network's point of view, he says, because "what's optimal for a single firm may be suboptimal for the network."

For example, in a recent paper, he shows that when firms make decisions about supply chains on the basis of their own projected profit margins, they sometimes create inefficiencies and weaknesses in a larger chain. He suggests that appropriately designed subsidies targeted at specific stages of the production process may be a cost-effective way to resolve these inefficiencies and bolster the robustness of the network. And in previous research, he demonstrates that the more firms diversify their supply chains to reduce risk, the more they potentially amplify the risks to the industry network.

Will COVID-19 change the way supply chains are designed? Probably not, says Bimpikis. Some firms might shift their outsourced manufacturing to India or other countries in Asia—correcting an overreliance on China—but the conditions that led to outsourcing in the first place remain the same.

"Firms will always need to balance cost versus risk," he says, and without the necessary incentives they are not likely to form supply chains much different than the ones they have today. "This is where government might play a role, if they deem that guaranteeing the availability of certain goods is critical for consumers."

What Role for Government?

The question is: What role should government play when it comes to protecting critical supply chains?

It's already the subject of fervent debate. In late April, Senate Democrats, invoking the Defense Production Act—a law originally meant to ensure supplies for national defense purposes—unveiled a bill to federalize the medical supply chain. Doing so, they argued, would help guarantee that the country has the ventilators and personal protective equipment needed to confront the ongoing crisis.

In addition to such emergency measures, Bimpikis sees a more enduring role for government: It can offer greater transparency of increasingly complex international supply networks. Knowing, for example, precisely where and how an essential medicine is produced could help save lives in the event of a disruption.

Consider Japan's experience after the 2011 earthquake and tsunami caused disruptions to its auto manufacturing industry. It turned out that most companies relied on a small group of suppliers in a geographic cluster—but this was only clear after the economic damage was done.

"I wouldn't advocate that government needs to take over supply chains," Bimpikis says. "But when it comes to products that are deemed essential, it would help if they had visibility. How many rely on a single region—or even a single firm? How strong are they? How diversified? How feasible would it be to ramp up production domestically in case of an emergency? Is there a strategic reserve that we can rely on if production is disrupted?"

Digitizing transactions—using blockchain technology—could be useful in this effort to achieve more transparency, he says. In fact, IBM has already launched its own blockchain designed to fill the gap between medical supply makers and the healthcare community.

Beyond monitoring supply chains, the government might consider offering firms incentives to build them in ways that are more socially beneficial. Such incentives might include tax breaks or subsidies for companies who "on-shore" some of their production, thus mitigating disruption risks.

"The point is that to achieve resilient supply chains, you can't just rely on firms," Bimpikis says. You'd need to nudge them in some way and compensate them for the positive externalities they create."

As Critical as Banks and Oil

Bimpikis points out that the government has intervened to protect other segments of the economy that it deems essential, such as banks. "There's no reason why the same concerns about the health of the banking sector shouldn't be extended to the health of supply chain networks," he says. "The government doesn't run the banks, but they are still required to hold a certain amount of reserves based on their position in the financial network."

Some have even called for the government to establish a "stress test" for companies that provide critical supplies, just as it did for banks in the wake of the 2008 financial crisis—but Bimpikis is skeptical that this is realistic.

He does, however, point to another instance of government intervention: the creation of the Strategic Petroleum Reserve in the wake of the 1973 oil crisis. If the government has a role to play in safeguarding the banks and preserving sources of energy, why not undergird supply chain networks by maintaining a strategic stock of critical supplies?

Perhaps a good analogy is the one closest to home: The shelter-in-place orders that have been imposed to slow the spread of COVID-19 illustrate how extensively networked we are and highlight the risks involved in operating as if that network didn't exist.

"Social distancing may impose a cost on the individual, but it also provides positive externalities to the population," Bimpikis says. "So there's a parallel between what we're all doing and what firms could be doing to protect their supply networks. Of course, firms are not as altruistic as individuals, and even people need some government nudging to encourage behaviors that are good for everyone."

More information: Supply Disruptions and Optimal Network Structures. stanford.edu/~kostasb/publications/disruptions.pdf
Provided by Stanford University